analysis of securities

1. Chapter 12
Fundamentals of
Corporate
Finance
Fifth Edition
Slides by
Matthew Will
McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
The Weighted-Average Cost of
Capital and Company
Valuation

2. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
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12- 2
Topics Covered
Geothermal’s Cost of Capital
Weighted Average Cost of Capital (WACC)
Measuring Capital Structure
Calculating Required Rates of Return
Calculating WACC
Interpreting WACC
Valuing Entire Businesses

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12- 3
Cost of Capital
Cost of Capital - The return the firm’s
investors could expect to earn if they
invested in securities with comparable
degrees of risk.
Capital Structure - The firm’s mix of long
term financing and equity financing.

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Cost of Capital
Example
Geothermal Inc. has
the following
structure. Given that
geothermal pays 8%
for debt and 14% for
equity, what is the
Company Cost of
Capital?

5. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
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Cost of Capital
Example - Geothermal Inc. has the following
structure. Given that geothermal pays 8% for debt
and 14% for equity, what is the Company Cost of
Capital?
100%
$647
Assets
Value
Market
70%
$453
Equity
Value
Market
30%
$194
Debt
Value
Market

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12- 6
Cost of Capital
Example - Geothermal Inc. has the following
structure. Given that geothermal pays 8% for debt
and 14% for equity, what is the Company Cost of
Capital?
12.2%
=
(.7x14%)
+
(.3x8%)
=
Return
Portfolio

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Cost of Capital
Example - Geothermal Inc. has the following
structure. Given that geothermal pays 8% for debt
and 14% for equity, what is the Company Cost of
Capital? 12.2%
=
(.7x14%)
+
(.3x8%)
=
Return
Portfolio
Interest is tax deductible. Given a 35% tax rate, debt only
costs us 5.2% (i.e. 8 % x .65).
11.4%
=
(.7x14%)
+
(.3x5.2%)
=
WACC

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WACC
Weighted Average Cost of Capital (WACC) -
The expected rate of return on a portfolio of
all the firm’s securities.
Company cost of capital = Weighted average of debt
and equity returns.

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12- 9
WACC
V
)
r
x
(E
+
)
r
x
(D
assets
equity
debt
r 
   
equity
V
E
debt
V
D
assets r
x
r
x
r 

s
investment
of
value
income
total
assets =
r

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WACC
Taxes are an important consideration in the
company cost of capital because interest payments
are deducted from income before tax is calculated.

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WACC
Weighted -average cost of capital=
[ ] [ ]
WACC = x (1 - Tc)r + x r
D
V debt
E
V equity

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WACC
Three Steps to Calculating Cost of Capital
1. Calculate the value of each security as a
proportion of the firm’s market value.
2. Determine the required rate of return on
each security.
3. Calculate a weighted average of these
required returns.

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WACC
Example - Executive Fruit has
issued debt, preferred stock and
common stock. The market
value of these securities are
$4mil, $2mil, and $6mil,
respectively. The required
returns are 6%, 12%, and 18%,
respectively.
Q: Determine the WACC for
Executive Fruit, Inc.

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WACC
Example - continued
Step 1
Firm Value = 4 + 2 + 6 = $12 mil
Step 2
Required returns are given
Step 3
[ ] ( ) ( )
WACC = x(1-.35).06 + x.12 + x.18
=.123 or 12.3%
4
12
2
12
6
12

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WACC
Issues in Using WACC
Debt has two costs. 1)return on debt and 2)increased cost of
equity demanded due to the increase in risk
 Betas may change with capital structure
 Corporate taxes complicate the analysis and may change
our decision
[ ] [ ]
B = x B + x B
assets
D
V debt
E
V equity

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Measuring Capital Structure
In estimating WACC, do not use the Book
Value of securities.
In estimating WACC, use the Market Value
of the securities.
Book Values often do not represent the true
market value of a firm’s securities.

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Measuring Capital Structure
Market Value of Bonds - PV of all coupons
and par value discounted at the current
interest rate.

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Measuring Capital Structure
Market Value of Bonds - PV of all coupons
and par value discounted at the current
interest rate.
Market Value of Equity - Market price per
share multiplied by the number of
outstanding shares.

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Measuring Capital Structure
Big Oil Book Value Balance Sheet (mil)
Bank Debt 200
$ 25.0%
LT Bonds 200
$ 25.0%
Common Stock 100
$ 12.5%
Retained Earnings 300
$ 37.5%
Total 800
$ 100%

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Measuring Capital Structure
Big Oil Book Value Balance Sheet (mil)
Bank Debt 200
$ 25.0%
LT Bonds 200
$ 25.0%
Common Stock 100
$ 12.5%
Retained Earnings 300
$ 37.5%
Total 800
$ 100%
If the long term bonds pay an
8% coupon and mature in 12
years, what is their market
value assuming a 9% YTM?
70
.
185
$
09
.
1
216
....
09
.
1
16
09
.
1
16
09
.
1
16
12
3
2






PV

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Measuring Capital Structure
Big Oil MARKET Value Balance Sheet (mil)
Bank Debt (mil) 200.0
$ 12.6%
LT Bonds 185.7
$ 11.7%
Total Debt 385.7
$ 24.3%
Common Stock 1,200.0
$ 75.7%
Total 1,585.7
$ 100.0%

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Required Rates of Return
Bonds
r = YTM
d
r = CAPM
= r + B(r - r )
e
f m f
Common Stock

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Required Rates of Return
Dividend Discount Model Cost of Equity
Perpetuity Growth Model =
solve for re
P =
Div
r - g
0
1
e
r =
Div
P
+ g
e
1
0

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Required Rates of Return
Expected Return on Preferred Stock
Price of Preferred Stock =
solve for preferred
P =
Div
r
0
1
preferred
r =
Div
P
preferred
1
0

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* FCF and PV *
Free Cash Flows (FCF) should be the
theoretical basis for all PV calculations.
FCF is a more accurate measurement of PV
than either Div or EPS.
The market price does not always reflect the
PV of FCF.
When valuing a business for purchase,
always use FCF.

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Capital Budgeting
Valuing a Business
The value of a business or project is usually computed as
the discounted value of FCF out to a valuation horizon
(H).
The valuation horizon is sometimes called the
terminal value and is calculated like PVGO.
H
H
H
H
r
PV
r
FCF
r
FCF
r
FCF
PV
)
1
(
)
1
(
...
)
1
(
)
1
( 2
2
1
1










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Capital Budgeting
Valuing a Business or Project
H
H
H
H
r
PV
r
FCF
r
FCF
r
FCF
PV
)
1
(
)
1
(
...
)
1
(
)
1
( 2
2
1
1









PV (free cash flows) PV (horizon value)

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Capital Budgeting
Example - Concatenator Manufacturing
.
7
.
376
,
2
05
.
085
.
2
.
83
Value)
Horizon 








           
20
.
368
,
1
085
.
1
7
.
376
,
2
085
.
1
5
.
43
085
.
1
7
.
27
085
.
1
9
.
102
085
.
1
1
.
87
085
.
1
72.5
-
PV(FCF) 5
5
4
3
2






